Home ownership is one of the most important aspects of life for many people. Home ownership is generally made possible through a mortgage whereby a lender acquires a conveyance of a property from a borrower as security for a loan to purchase the property. Upon payment of the mortgage according to stipulated terms, the conveyance is void and the borrower is the owner of the property.
Mortgages may be typically classified into two categories, prime, or conforming loans, and sub-prime, or non-conforming loans. Classification is typically based upon a borrower's income level, credit rating, and the borrower's ability to make a down payment for the mortgage. Under a prime mortgage loan, the borrower gives the lender a mortgage in exchange for money to purchase property. The lender typically requires the borrower to purchase mortgage insurance if the loan-to-value ratio is greater than 80 percent. This protects a lender by allowing the lender to sell the mortgage in the secondary market. Such a secondary market may be created so that primary mortgages can be bought and traded by investors, allowing initial lenders to remove the mortgages from its books.
A sub-prime mortgage loan may be offered to those borrowers who may not qualify for a prime mortgage loan. However, a problem associated with offering sub-prime mortgage loans is inefficient pricing of the sub-prime mortgage loans. Specifically, efficient pricing of sub-prime mortgage loans may be difficult due to higher default and severity rates. Default and severity rates refer to the anticipated amount of homebuyers that will fail to fulfill their payment obligations, and the percentage of money a lender may lose on each of those mortgages, respectively. Higher default and severity rates often cause lending institution to charge higher interest rates on sub-prime mortgages than the interest rates offered for prime mortgage loans.
Sub-prime mortgage loans are often packaged and offered to mortgage finance companies in bulk of redistribution to sub-prime borrowers. A collection of borrowers with sub-prime mortgage loans may be referred to as a mortgage pool. Since a borrower with a sub-prime mortgage loan may develop a better credit rating, the borrower may refinance with a prime mortgage loan to obtain a reduced interest rate for the remainder of the payment obligation. The anticipated exit of quality borrowers from the collection of borrowers with sub-prime mortgage loans causes a lending institution to charge an even higher initial mortgage rate for sub-prime mortgage loans in the mortgage pool. Increasing interest rates to account for the loss of quality borrowers from the mortgage pool causes the development of a cyclical pattern of quality borrowers leaving the mortgage pool, and lenders increasing mortgage interest rates. This cycle is known as turning a mortgage pool toxic, because eventually only the borrowers that cannot qualify for a conforming loan, the highest risk borrowers, remain in the mortgage pool.
Despite the volatile and risky environment surrounding the provision of sub-prime mortgage loans, there is considerable pressure from government agencies on lending institutions and government sponsored entities to issue an increasing number of these mortgage loans. This pressure stems from enactment of the Community Reinvestment Act (CRA). The CRA is intended to encourage depository institutions to help meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods, consistent with safe and sound banking operations. The CRA requires that each insured depository institution's record in helping meet the credit needs of its entire community be evaluated periodically. As a policing authority, the act established regulatory agencies for monitoring and grading banks on their level of lending, investment, and providing services to low- and moderate-income (LMI) neighborhoods. The federal agencies conducting CRA examinations include the Office of the Comptroller of the Currency that examines nationally chartered banks, the Office of Thrift Supervision that examines savings and loan institutions, and the Federal Deposit Insurance Corporation and the Federal Reserve Board, both of which examine state chartered banks. With respect to mortgage loans, the CRA is dedicated to the increased provision of loans to LMI borrowers, who often only qualify for sub-prime mortgages. However, as stated previously, profitable pricing of LMI mortgage loans to account for higher default rates and loss severity continues to be difficult. The practical problem realized by banks in their efforts to meet CRA performance requirements is that a relatively high percentage of loans made to sub-prime borrowers result in default. Nevertheless, in order to maintain a satisfactory CRA rating, banks are obliged to assume the risk of non-payment. The possibility of higher losses may cause banks to be reluctant in supporting community development projects.
Additionally, the relationship between various housing agencies seeking to provide low- to moderate-income housing and lending institutions may be tense, as these parties often have conflicting interests. A housing agency may be a public housing authority that may be primarily responsible for housing, urban and community development programs, and other related programs. A housing agency may be an agency organized under the US Department of Housing and Urban Development (HUD). These agencies are typically not-for-profit agencies whose primary activity may be the insuring of residential mortgage loans made by private lenders. By providing mortgage insurance to lenders to cover most losses that may occur when a borrower defaults a housing agency may encourage lenders to make loans to borrowers who might not qualify for conventional mortgages. However, these agencies often have limited funding and restrictive budgets, preventing them from meeting all of their affordable housing goals and placing them in conflict with lending institutions. For example, a housing agency may desire to increase the number of LMI mortgage loans issued, whereas a lending institution may desire to keep its credit risk to a minimum. This tension further exacerbates the problem of locating quality LMI borrowers and providing mortgage loans to these borrowers at rates competitive enough to prevent them from exiting the mortgage pool.
Consequently, a method of providing lower cost mortgage funding to sub-prime borrowers is necessary.